Short-answer questions



Sample Quiz Answers, 10/05/03.

Question 1. (4 points)

Please answer Uonly oneU of the two questions.

1. As we know, Hong Kong has a fixed exchange rate regime (currency board). Suppose Hong Kong runs consistently BOP surpluses. If we believe in the BOP approach to exchange rate determination, what will we expect happening to the HK$/US$ rate? Why?

The HK$/US$ rate will revaluate. According to the BOP approach of exchange rate determination, the surplus on BOP indicates high demand for the HK$, so its price (exchange rate) in US$ will increase.

2. Why surplus in the current account will lead to an appreciation of the home currency, if we believe in the portfolio-balance approach to exchange rate determination?

A surplus in the current account implies more financial wealth coming into the country, which then will translate into higher demand for the country’s currency (businesses and individuals in that country, being wealthier, will keep their wealth locally, so the demand for the domestic currency will increase).

Question 2. (4 points)

Please answer Uonly oneU of the two questions.

1. Who are the main participants in the forex market (give me at least three of them). Briefly describe why are they in the market (e.g for profit, speculation, hedging purposes).

The main participants in the forex market are:

1. Bank and Non-bank Dealers (they are in the market trading for profit through the bid-ask spread)

2. Businesses & individuals (they enter the market to facilitate underlying investment or commercial transactions).

3. Speculators & arbitrageurs (they are in the market seeking to profit from the volatility of exchange rates).

4. Treasuries & Central Banks (they use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded).

5. Brokers (facilitate trade between dealers without themselves becoming principals in the transaction).

2. Suppose the bid quote for the spot rate is Yen 118.27/ $ and the quote for the 90-days forward is –140 points. What is the outright 90-days forward quote? What is the percentage forward premium/discount on the yen?

Since this is a quote on the Yen, the point basis id only to two decimal points. So, if the outright quote is Yen 118.27/ $, then the forward rate is Yen 118.27/ $ - 1.43 = Yen 116.84/ $. Since this is an UindirectU quotation (from the US point of view), the forward premium/discount is given by

[pic], or the Yen is traded at a forward premium.

Question 3. (4 points)

Please answer Uonly oneU of the two questions.

1. Suppose you have the following quotations

|Bank |Quotation |

|Fuji Bank, Tokyo |SYS120/$ |

|Credit Suisse First Boston, New York |SF 1.60/$ |

|Swiss First Bank, Zurich |SYS80/ SF |

Assume that you have an initial SF 1,000,000. What is the cross-rate of Yen/SF? Compare it w/ Swill First Bank Yen/SF quote. Any triangular arbitrage opportunity? If yes, sketch briefly an arbitrage. If no, why?

UNote:U no need for numerical answer, full credit given for setting up calculation & showing where to plug in the given info.

There are three ways to go for setting up the arbitrage (you can do it w/ the SYS/$, SYS/SF, and SF/$ rates).

Here, I will use the SYS /SF rate to check for triangular arbitrage.

UStep 1.U First, we have to compute the SYS /SF cross rate is: SYS120/ SF / SF 1.6/$ = SYS75/$

UStep 2.U Since the cross rate above is not same as the Swiss First Bank rate of SYS80/$ there is an arbitrage opportunity.

UStep 3.U Here we set up the arbitrage. Here is the general idea. Clearly, you have to sell SF at the high rate, and then buy back the SF at the low rate.

So,

A. Sell SF 10,000,000 for Yen @ Swiss First Bank in Zurich @ SYS80/ SF to get: SF 10,000,000 x SYS80/ SF = SY S800,000,000.

B. Now we have to get back these proceeds to SF, but at the cross rate: so exchange the proceeds SY S800,000,000 @ SYS120/$ for US$ to receive SYS800,000,000 / SYS120/$ = $ 6,666,666.67 from Fuji Bank in Tokyo.

C. Finally, get these $ proceeds into SF, @ SF 1.6/$ to receive $ 6,666,666.67 * SF 1.6/$ = SF 10,666,666.67 from Credit Suisse First Boston in New York.

D. What is the profit? We started w/ SF 10,000,000 and ended up w/ SF 10,666,666.67.

2. Suppose you have $10 million and wish to speculate on the Euro (. Current 30-day forward is $0.90/EUR. You believe that spot in 30-days will be $0.844/EUR. Can you make an arbitrage profit? If yes, show how. If no, why?

Yes, there exists an arbitrage opportunity, if at maturity the spot rate is indeed $0.844/EUR. One can sell forward the Euro and at maturity go to the spot market to purchase Euros.

UStep 1.U Sell Euro 30-days forward to receive $ 10,000,000 / $0.90/EUR = EUR 11,111,111.11.

UStep 2.U At the end of 30 days, buy these Euros spot for EUR 11,111,111.11 x $0.844/EUR = $ 9,377,777.78.

UStep 3.U At the end of 30 days, sell Euros at forward rate to receive $10,000,000.

The net profit of this strategy is $622,222.22.

Question 4. (4 points)

Please answer Uonly oneU of the two questions.

1. Give me three differences b/n futures and forward contracts.

1. Counterparties contact through the clearing house in the case of futures and directly in the case of forwards.

2. The pricing of the futures is in an exchange, with open outcry system (that is traders bid on prices in the pit of the exchange) while for forwards the pricing is through bid/ask quotes.

3. Maturities for futures are standardized, while maturities for forwards can be tailored for the specific needs of the counterparties.

4. Futures are traded on organized exchanges while forwards are traded between businesses (individuals) and banks.

2. Suppose you wish to speculate on the British pound futures, traded @ Chicago Mercantile Exchange. The following quotations are available:

|British Pound Futures, US$/pound |Contract = 62,500 pounds |

|Maturity |Settle price |

|Mar |1.4228 |

|June |1.4162 |

If you sell ten (10) March pound futures, and the spot rate @ maturity is $1.398/pound, what is the value of your position at maturity?

If you sell 10 March pound contracts at $1.4228/Pound and then at maturity the exchange rate is $1.398/Pound then the value of the contract is

= - Principal * (Spot – Futures) = - 62,500 pounds x ($1.398/Pound -$1.4228/Pound) = $1,550.

Notice that since we have 10 March contracts, we have to multiply the value of each contract by the number of contract, to obtain the value of the position of $1,550 x 10 = $15,500.

Question 5. (4 points)

Please answer Uonly oneU of the two questions.

UNote: since we have not covered the material for options completely, the following question will NOT be given on the quiz. I will adjust the content of question 5 accoringly.

1. What type(s) of options would be in-the-money if the current spot price were greater than the exercise (or strike) price? (i.e. short or long, put or call) Give a brief payoff diagram(s) of the option(s) of choice.

or

2. Suppose that you have choice of two options on the US$/ Singapore $ exchange rate:

|90-days maturity European options |Strike Price |Premium |

|Put |$0.65/S$ |$.00003/S$ |

|Call |$0.65/S$ |$.00046/S$ |

a. Suppose spot rate is $0.60/S$. If you expect an appreciation of the S$ to $0.70/S$, which option will you buy?

b. What will be the profit for the option of choice if the spot rate in 90-days is indeed $0.70/S$?

UNote:U no need for numerical answer, full credit is given for just setting up the calculation and showing where to plug in the given info.

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